Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Voting rights of hedged equity

US SEC Commissioner Paul Atkins in his talk
at the Corporate Directors forum this week raised the issue of “empty
voting” by those who have used derivatives to hedge the economic risk
of their shareholding.

First of all, it is unfortunate that Atkins raised this issue in
the context of the debate about giving shareholders more rights in the
election in the directors. If “empty voting” is a problem
at all, then it is a problem for all shareholder resolutions and not
just the election of directors. By raising the issue in this context,
Atkins sends an unfortunate and inappropriate signal to the investors
about the SEC’s approach to the problem.

Second, the potential for the separation of voting rights and
economic rights existed even without derivatives. Supervoting shares
is one way in which separation occurs. For example, in the case of
Google, each of the Class B shares held by the founders has ten times
the voting rights of the Class A shares held by others. Google
management controls a majority of the voting rights with a much
smaller economic interest in the company.

Tracking shares are another way in which separation
happens. Holders of tracking shares in a division of a company own the
entire economic interest in the division, but the board has no
obligation to them as opposed to their obligations to the company as a
whole. This means that holders of the tracking stock own a division
without controlling it and the holders of the regular stock control
the division without owning it.

When all these mechanisms have been in existence for decades, it is
strange that the SEC finds only the use of derivatives troubling. The
nice thing about derivatives is that they are traded in an open market where
everybody is welcome to play the game. You do not have to be the
founder of a company to unbundle a share into economic rights and
voting rights using total return swaps or other means. In an efficient
market, the economic interests and the voting rights will both be
valued in the market and anybody can buy or sell voting rights at this
market price. Once everybody realizes that this can be done, both
sides in any proxy battle or takeover struggle will use this
method. It is then a level playing field.


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